As was true for most of the world, 2008 was a challenging year for the business community in Canada. Nonetheless, Canada is ahead of most of the industrialized world in virtually all leading indicators. More importantly, Canada remains strongly positioned to support business activity when economic recovery begins. In this article, we review some important developments for U.S. and other foreign companies and investors in federal government research and development programs, tax, securities laws and foreign investment. All dollar amounts discussed are in Canadian dollars.

Scientific Research and Experimental Development
Canada is very attractive for R&D activities due to the high caliber of Canadian research, the highly educated work force, and a very competitive cost environment. Canada's scientific research and experimental development (SRED) tax credit program is one of the most generous R&D incentive support programs in the world.

The tax incentives are delivered through the Income Tax Act (ITA). In 2006, the federal government provided over $3 billion in tax assistance to Canadian businesses doing R&D. Unlike the comparable U.S. program, the SRED program is not subject to annual budgetary limitations and funding under the program is unlimited.

The SRED program has various components. First, R&D costs, including capital expenditures and costs incurred outside Canada, are fully deductible for Canadian tax purposes. Second and more important from a funding perspective, qualifying SRED expenditures generate investment tax credits (ITCs).

Under the program, ITCs are earned at the ordinary rate of 20 percent of SRED expenditures and can be applied against Canadian tax liability. For Canadian-controlled private corporations, ITCs are earned at the enhanced rate of 35 percent and are fully refundable; if the ITC amount exceeds tax liability, the corporation gets a check for the difference. SRED costs up to the expenditure limit, currently $3,000,000, are eligible for the enhanced refundable credits.

A Canadian-controlled private corporation need not be controlled by Canadians or very closely held. Rather, a Canadian-controlled private corporation cannot be controlled by non-residents or public corporations; 50-50 ownership arrangements between U.S. and Canadian investors can qualify. Consequently, careful consideration should be given to whether an R&D entity can be structured as a Canadian-controlled private corporation.

An R&DCo may be established in Canada for the express purpose of conducting R&D and may qualify for ITCs, including refundable ITCs at the enhanced rate, if the R&DCo is structured as a Canadian-controlled private corporation. If properly designed, the R&DCo may contract with a non-resident to perform R&D activities in Canada on behalf of the non-resident, with the non-resident owning the resulting technology. Therefore, in appropriate circumstances, an R&DCo could enjoy the full funding benefit of refundable ITCs at enhanced rates, providing significant non-dilutive funding for its future operations.

The SRED program, when combined with complementary provincial programs, is an important element in Canada's attractiveness for research and development activity. When the enhancements resulting from qualifying as a Canadian-controlled private corporation are available, it can also be an import source of significant financial benefit to corporations locating in Canada.

Cross-Border Tax Rules
During the past year, significant changes were made to tax rules applicable to transactions between U.S. investors and Canadian corporations.

Limited liability companies. The Canada-U.S. Tax Convention 1980 (Treaty) has been amended to improve the tax treatment for members of a limited liability company (LLC) that invests in a Canadian corporation. Prior to these new rules, for a number of technical reasons, LLCs did not benefit from the Treaty. Consequently, to obtain Treaty benefits, including reduced withholding tax on payment of income across the border, U.S. private equity funds and other U.S. investors that are often structured as LLCs had to engage in complex and inconvenient structuring when investing in Canadian corporations. Under the new rules, U.S. resident members of LLCs will benefit from the Treaty, allowing LLCs to invest directly in Canadian corporations.

Interest payments. Another important change eliminates withholding tax on interest paid to unrelated and arm's length U.S. residents by a Canadian resident. The elimination of withholding tax on interest paid to related parties will be phased in over the next three years. Prior to this change, a Canadian borrower was required to withhold tax at a rate of 10 percent unless the terms of the loan met certain strict conditions, again requiring convoluted and inefficient structures to avoid the withholding tax. The change should facilitate access for Canadian businesses to U.S. capital markets.

Disposition of taxable Canadian property. A major concern for non-resident investors in Canada has been the requirement to obtain advance clearance certificates under Section 116 of the ITA when the non-resident disposes of "taxable Canadian property" (TCP). The definition of TCP is quite broad and includes shares of private Canadian corporations. If a non-resident vendor does not comply with Section 116, the purchaser is liable for the payment of the withholding tax. The certificate clearance process is administratively difficult, requiring the vendor to provide a significant amount of information to the Canada Revenue Agency (CRA), and often takes several months, delaying the vendor's receipt of all of the disposition proceeds.

The ITA has now been amended: If a person purchases property from a non-resident vendor and the purchaser is satisfied that the vendor is resident in a jurisdiction that Canada has a treaty with, and the disposition of the property by the vendor would not be subject to Canadian tax by reason of that treaty, the vendor need not obtain a Section 116 certificate. Additionally, the non-resident vendor will no longer be required to file a Canadian income tax return in respect of such disposition. While these changes are welcome, the practical application of the revised Section 116 remains unclear. Purchasers will likely be very careful in determining the residence of vendors, including the residence of members of U.S. LLCs, resulting in complications and disclosure that LLCs and other investors may be unwilling or unable to provide. In the absence of such disclosure, purchasers may still require that the non-resident vendor obtain an advance clearance certificate. The CRA has not yet provided guidance for purchasers in these situations.

Doing Business with Public Companies
During 2008, there were a number of significant securities and corporate law requirements applicable to Canadian public companies.

Material contract filing requirements. The Canadian Securities Administrators (CSA) broadened the obligations of Canadian public companies to publicly file material contracts on SEDAR (Canada's equivalent to EDGAR in the U.S.) to include contracts entered into in the ordinary course of business. Examples include continuing contracts to sell the majority of their products or services or to purchase the majority of their requirements of goods, services, or raw materials; and franchise or license or other agreements to use a patent, formula, trade secret, process, or trade name. These requirements affect both public and private companies (Canadian or otherwise) that enter into contracts that are material to Canadian public companies. U.S. companies entering into such contracts with Canadian public companies should be aware of these requirements.

Certification. The CSA has updated requirements relating to certification by senior officers, in particular, regarding internal control over financial reporting (ICFR). In addition to certifying the design of, and disclosing any material change, in ICFR, Toronto Stock Exchange-listed companies must provide certification on a number of different elements relating to the controls, weaknesses, and evaluation of ICFR. Significantly, unlike U.S. rules, Canadian rules do not require attestation of ICFR by a company's auditors, a material cost and time benefit for Canadian public companies.

Directors' duties in M&A transactions. The Supreme Court of Canada (SCC) recently released its decision relating to the fiduciary duties of the directors of BCE in connection with its proposed (but failed) $52 billion privatization. Under Canadian law, directors have a statutory fiduciary duty to act in the best interests of the corporation. In the context of merger and acquisition transactions, Canadian lawyers had looked to the U.S. Revlon line of cases for support in advising directors to favor the interests of shareholders over other stakeholders. However, in its decision, the SCC confirmed that, under Canadian law, there is no hard and fast rule that the interests of shareholders must always trump those of other stakeholders in an M&A context. The directors' statutory fiduciary duty is to the corporation and, therefore, directors are permitted to consider the impact of corporate decisions on other stakeholders, as well as shareholders. The SCC indicated that everything depends on whether the directors exercise business judgment in a responsible way.

Foreign Investment Law
In April 2008, the Canadian government refused to give its approval to the proposed acquisition of the space technology division of MacDonald, Dettwiler and Associates (MDA) by Alliant Techsystems Inc., a U.S. arms manufacturer and defense contractor. The proposed acquisition included the space-based radar systems, space robotics, satellite systems and intelligence, surveillance, and reconnaissance capabilities of MDA. The decision received considerable publicity, raising concerns about Canada's openness to foreign investment.

The Investment Canada Act governs reviews of foreign investments in Canada. Investments exceeding a designated financial threshold are subject to review. The threshold for review for an investment from a World Trade Organization country is currently $295 million (an increase in the threshold to $1 billion is likely in the near future). For the financial services, transportation services, uranium, and cultural sectors, the thresholds are substantially lower.

To obtain approval, a prospective investor must demonstrate that the investment is likely to be of "net benefit to Canada." The Investment Act Canada enumerates a number of factors to be considered, but does not spell out how the net benefit test is applied or what combination of factors must be met.

The Alliant decision is unprecedented; every other government review since 1985 has been approved. The decision to block Alliant's acquisition may be limited to the transaction's unique circumstances. MDA's space division developed the iconic Canadarm - a source of Canadian national pride. MDA also developed and owns Radarsat-2, viewed as essential technology in protecting Canada's sovereignty, particularly over the vast Arctic waters and the rich resources that lie beneath those waterways. Jurisdictional questions over the transfer of Radarsat-2 technology, and uncertainty over the possibility that the U.S. government could restrict Alliant from delivering critical satellite data to the Canadian government, were factors in the government's decision.

Canada's foreign investment law does not contain an explicit national security test for foreign investments, although protecting national security and critical infrastructure has been on the government's radar screen. The Alliant transaction may have crystallized the issues that are critical to a national security test.

The Minister of Industry, in a speech given at a space industry event, expressed the need, in a knowledge-based economy, to own our technology and the intellectual property that comes with it. He said, "When it comes to decisions on whether foreign purchases represent a net benefit to Canada, my bottom line is this: Canada must retain jurisdiction and control of technologies that are vital to the future of our industry and the pursuit of our public policy objectives." These principles - never before articulated by the federal government - may establish a new approach to assessing the net benefit to Canada in the case of high-tech industry acquisitions or just be limited to the space industry.

In our view, while the Alliant decision did receive significant publicity, foreign investors should not be concerned that the case represents a dramatic shift to Canada's general receptiveness to foreign investment.

Robert Ford, Michael Herman, Kathleen Ritchie, and Catherine Pawluch are partners in the Canadian law firm of Gowling Lafleur Henderson LLP (Gowlings), which offers a diverse range of services to help domestic and international organizations achieve their business objectives. They can be contacted via the Gowlings website, www.gowlings.com. For a more comprehensive overview of legal issues to be considered if a company wants to set up business in Canada, please refer to the Gowlings "Establishing a Business in Canada" guide, which can be accessed at www.gowlings.com/DBIC/. This article is for information purposes only; it is not and should not be taken as legal advice.